Thesis’ Hoggarth: Will China falls lead to full blown market crash?

The surprise currency devaluation by the Chinese authorities caused concern in the markets that the country’s growth may be even weaker than had been feared. Was the slowdown so dramatic that the currency had to be devalued in order to boost exports?

The exchange rate shift was followed by the release of poor manufacturing figures and Chinese equities, which were already 25 per cent below their June peak, dropped again. Market sentiment was already weak as a rise in US interest rates seemed imminent and share valuations were at high levels. The global reaction was more skittish than it otherwise might have been because of the low volume of shares traded while many investors were on holiday. The FTSE All Share fell 11.6 per cent between August 10th and 24th.

Market falls are never pleasant, but equity investing requires a long-term perspective and previous market dips, falls and crashes may tell us something useful about the current situation.

Looking at the FTSE All Share Index return, excluding dividends, in each complete year since its launch in 1962 it shows a short-term loss does not necessarily turn into a long-term one. In 45 of the past 52 years the UK equity market has experienced a fall of more than 5 per cent at some point during the year, but in 30 of these years the market still ended the year higher than it began.

The average intra-year loss is 15.3 per cent, while the average market rise over a full calendar year is 10.2 per cent. This highlights the volatility of equity markets, but also the opportunity for investors who can take a long-term view and ride out the peaks and troughs.

But buying a stock or market whose price is going down is often likened to catching a falling knife – it is easy to get hurt. At its lowest close during the current episode the All Share Index was 15.3 per cent below its peak. Was this the full extent of the drop, or might there be more pain to come?

Since its launch in 1962 the FTSE All Share Index has on 21 occasions fallen by more than 10 per cent from a previous high. Some were sharp drops with swift recoveries, such as the 1997 Asian crisis or the 2013 taper tantrum. Other episodes have seen much deeper losses and longer times to recovery, such as the credit crunch of 2008, the bursting of the dotcom bubble between 2000 and 2003 and the joint upset caused in the early 1970s by the Nixon government’s abandonment of the gold standard and the first oil shock.

When looking at the biggest falls and the longest times taken to recover, it is noticeable that the deepest crashes and longest times to recovery have tended to occur when the market falls happen at the same time as a recession. In some cases, such as the 2000-03 technology crash, the UK avoided recession but there was a fall in US output.

It makes sense from a theoretical point of view that recessions would worsen market falls. If the stockmarket works efficiently then share prices should reflect the value of dividends that shareholders expect to receive in the future. A recession will on average lead to lower consumer and business spending, corporate revenues and profits will therefore be lower and dividends will be cut, or at least grow more slowly, leading to lower prices.

The most significant exception is the Black Monday crash of 1987. This was caused by a slowing pace of growth rather than an outright recession, and so would normally have been expected to be less extreme. However, the fall was amplified by tensions in the Middle East and the effect of program trading, in which computer-generated orders intensified market movements.

Of course past performance is not a reliable guide to the future, and in reality each fall needs to be assessed in its own context.

So what of today’s situation? In the coming weeks and months we expect markets to continue to be volatile. A rapid rise to previous levels, known as a V-shaped recovery, seems unlikely in the present environment.

Interest rates will probably start to rise in the US by next spring, China’s economy and stockmarket are still a concern and Europe and Japan remain below par. Share prices have fallen back somewhere close to fair value but not to extremely cheap levels. There is a possibility of further falls, but at present we are not predicting a full blown market crash.

One reason for this is that although the world economy is growing at a slow pace we do not foresee a recession. The UK and US economies are in reasonable health, Japan and Europe are well supported by quantitative easing and corporate balance sheets are generally in good health. Growth should continue, even if it is at a marginally slower pace.